Frozen-Out Minority Shareholder Still Owed Corporation Fiduciary Duty

Massachusetts law is clear: both majority and minority shareholders of a closely-held corporation owe each other (as well as to the corporation) a fiduciary duty–a duty of utmost good faith and loyalty. In 1975, the Massachusetts Supreme Judicial Court held in the leading case of Donahue v. Rodd Electrotype Co. of New England, Inc., that as in partnerships, “the relationship among stockholders [of a close corporation] must be one of trust, confidence, and absolute loyalty if the enterprise is to succeed.” (A “close corporation” is when there are a small number of shareholders, no ready market for corporate stock, and substantial majority stockholder participation in management, direction, and operation of the business.)

Recently, the SJC issued an important decision clarifying the applicability of the fiduciary duty of a minority who has been wronged by the majority. The case, Selmark Associates, Inc. v. Evan Ehrlich, involved a very complicated factual background, but the important facts were that Selmark and Ehrlich were to become shareholders in a company, Marathon Sales, Inc. Pursuant to the purchase agreement, Selmark was to own 51% of Marathon and Ehrlich was to own 49%. In addition to the purchase agreement, the parties also entered into an employment agreement, conversion agreement and stock agreement.

The issue before the Court was whether the fiduciary duties of a minority shareholder to the corporation continued once said minority shareholder had been “frozen-out” or wrongfully terminated by the corporation. The Court answered in the affirmative.

At trial it was determined that the majority shareholder, Selmark, breached its fiduciary duties by terminating Ehrlich, the minority shareholder employed with Marathon. After his termination, Ehrlich took a job with one of Marathon’s competitors, Tiger Electronics, and solicited Marathon’s customers. Marathon contended that Ehrlich was in breach of his fiduciary duty in doing so. Ehrlich argued that because he was wrongfully terminated and frozen-out from his rights as a minority shareholder, he was relieved of fiduciary duties to the corporation.

The Court disagreed. “Allowing a party who has suffered harm within a close corporation to seek retribution by disregarding its own duties has no basis in our laws and would undermine fundamental and long-standing fiduciary principles that are essential to corporate governance,” wrote the Court. The Court also cited and quoted a case from another jurisdiction: “If shareholders take it upon themselves to retaliate anytime they believe they have been frozen out, disputes in close corporations will only increase. Rather, if unable to resolve amicably, aggrieved parties should take their claim to court and seek judicial resolution” Thus, self-help actions by a wronged minority shareholder were not permitted. (Interestingly, it is a general principle of Massachusetts contract law that where one party materially breaches its contractual obligations, it excuses the other party from further performance under the contract. The Court did not discuss this concept.)